5 reasons to buy new funds, ETFs, and 5 not to

About 2.4 new mutual funds are being created each day

BOSTON (MarketWatch) — In the middle of the current economic crisis, it doesn’t just seem like a new mutual fund — promising some new and better way to attack the market — is created every day. About 2.4 have been created each day, on average, so far this year.

Through the first half of 2011, some 440-plus new mutual funds and exchange-traded funds opened for business, according to Lipper Inc. At 2.4 per day, that’s 56% ahead of the pace of fund creation in the same period in 2010. Some are new twists on old investment ideas, others involve money managers expanding private accounts into public funds, and still others are newfangled concepts.

There’s a market for all of them, because “new” is a concept that resonates and sells with the investing public. With the pace of fund creation not likely to slow through the rest of the year, here are five reasons to consider buying into a new fund — and five reasons to stay away.

5 reasons to buy new funds

1. New means small and nimble. This applies to actively managed funds and ETFs — but not index flavors — and it’s a cause of “new fund phenomenon,” the tendency of new funds to outperform when first opened.

“The biggest problem in the mutual-fund industry is that funds get too big and over-diversify,” said C. Thomas Howard, director of research for AthenaInvest Inc., a research firm in Denver. “New funds are smaller and tend to hold fewer positions. The manager can react quickly, and those moves will have a bigger impact on performance than in a large fund.”

2. New also means concentrated, even if by accident. Howard and others noted that even if a fund’s prospectus says it will be “diversified,” the portfolio will still be relatively concentrated when the doors first open. Funds that are focused and concentrated in specific investment areas — designed to have fewer holdings — are more likely to experience new fund phenomenon, but all new funds typically have the manager’s best investment ideas. Managers don’t settle for secondary buys until the assets roll in and they are forced to spread the money around.

3. You know/like the manager. When good managers split off on their own — or when your personal money manager opens up a mutual fund — there’s an inherent trust and confidence there. When you believe in management’s ability to build something, it’s a good reason to get in on the ground floor.

4. It does something different. This is more true in the ETF space than in traditional funds, where new flavors tend to appeal to different investment tastes. For example, the new ProShares Hedge Replication
HDG, +0.16%
is a new spin on using an ETF as an alternative to hedge funds, which might be attractive to someone who has never had the wherewithal to invest in hedge funds directly.

5. It lowers your costs. Typically, new funds are more expansive than their average peer, but many advisory firms that start a fund are managing it the same way they run separate accounts. If you like what the manager does in your private account, you may like it even more if it comes cheaper in fund form, provided the tax consequences of moving from a separate account into a fund aren’t too big. If the new fund raises your costs, that would be an extra reason to avoid it.

5 reasons to avoid new funds

1. There’s no track record. Even if you like the manager and their past performance, a new fund is a whole new ball game. The fund graveyard is littered with issues started by solid money managers whose tactics didn’t work that well in the confines/restrictions of a fund.

2. The idea is unproven. Back-testing investment concepts — running data on what would have happened if the fund or its strategy had been around in the past — is not the same as managing money in the real world. And some things that seem great on paper just don’t pan out. That new ProShares hedge alternative, for example, sounds promising, but anyone reading the prospectus would have a slew of questions about whether the strategy will pay off.

3. There’s nothing new under the sun. With thousands of funds to choose from, you don’t need a new one. The best fund ideas have been around for years, some dating back nine decades; disdaining the old standards for something created nine days ago is folly.

4. It may not be around long. Another truism for the ETF space, where firms seem to throw up new ideas just to see what sticks. What’s more, even if the strategy works, a new fund might close from lack of support or interest. It’s not just fund openings that are on the rise; fund closings are too, and young funds make up a lot of the death toll.

5. New isn’t always improved. Sometimes a new fund is an asset grab by management, an attempt to cash in on something hot, or to keep you from taking a slice of your money to the competition. If it feels more like an expansion of the line-up than something management believes in, take a pass. There will be another new fund for your consideration every few hours.

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